Venture capital, business loans, and lines of credit: all this and more exists for businesses that need to grow, to purchase equipment and inventory, or expand their facilities. Much of the initial growth for small businesses is funded on borrowed money. It’s the way things are done. But it comes at a cost.
In the last few years, however, many small businesses have begun to move away from acquiring business debt either by choice or — and this is something which is occurring more frequently — by circumstance. The tightening of credit, loss of access to capital, and the general skittishness among potential investors and lenders has made the prospect of boot-strapping a business a much more attractive option. Sometimes it is the only viable option.
But is running and growing a debt-free business practical? What are the downsides? And more importantly, what are the advantages of building a business without borrowed money?
Starting from scratch or changing course
Financing a new business without borrowed money is challenging and it takes time. This is probably the first reality an entrepreneur has to come to grips with if you choose this route: you have to start relatively small and be prepared to take a longer period of time to reach your goals.
Another downside is the potential for seeing competitors gain market-share and gross revenue much more quickly as they take on borrowed capital to fund their marketing and production efforts. While the tables may well be turned down the road, at the start, this can lead to discouragement and second thoughts about maintaining a debt-free strategy.
More traditional businesses that have incurred debt from borrowed capital have a different set of challenges when making the move to become debt-free. If the business owner is not already intimately familiar with the company’s finances, this is the first order of business. You will need to know where the money goes and the business’ real profitability, among other things. If the business is not using an operations budget, this too, will need to be developed and put into play. And it must be used as a strategic tool along with a comprehensive cash flow management plan. Diligence will be required as well as a total rethinking of “how we do business” if the company is going to decrease expenditures, increase cash flow and pay off the existing debt.
While business owners may find this to be an intimidating prospect, the evidence shows that during economic downturns the less debt a business holds, the greater the odds of that business surviving. And when the economy is looking brighter, the debt-free business is in the strongest position to take advantage of the opportunities.
A few years ago, an investment blogger noticed that among a relatively random selection of stocks from high-debt companies the average year-to-date return was -6.9%. An equally random selection of debt-free companies tallied up an average return of +18%. While this was not a scientific study by any means, it does serve to illustrate the fact that companies without debt can be (and often are) more profitable than those carrying a significant debt load.
One of our clients has operated from a no-debt perspective since going into business over ten years ago. More recently, he began to diligently and consistently reinvest a portion of his monthly earnings into a “cash reserve” fund over a number of years with the goal of having at least a year’s worth of operating capital available. This fund served him well during the recent economic downturn when he needed to invest in added staff and equipment in order to take advantage of new opportunities that he would not have been capable of taking on at his previous size.
His competitors, on the other hand, were in the throes of downsizing and cost-cutting while still servicing the debt they had incurred during the previous “boom” years. As their overall profitability declined so had their flexibility – they were not in positions to compete for the opportunities that my client was able to secure for his own company.
Another tactic that has served him well is to maintain a “cash-only” policy with his customers. While he does provide for a one-half payment on acceptance of a project and the second half upon completion, this arrangement allows him to operate in the positive throughout the duration of his projects. And he can offer his clients a slightly lower fee since he does not have to finance receivables for 30 or 45 days like his competitors do.
The upside of all this is that business owners who are operating without business debt have a greater degree of financial freedom and flexibility, and a much lower degree of risk in the face of economic downturns and declines in business. And then there is the old proverb, “The borrower is the servant of the lender.”
Sacrificing the fast track for slow growth
For the majority of businesses that opt for a debt-free model, business growth tends to be slow. Jay Steinfeld, CEO of Blinds.com, the world’s largest online retailer of window coverings, made it a point to get – and stay – debt-free. “It’s been our goal to grow inch by inch, never spending beyond our means,” Steinfeld said. “We’ve done it all debt-free!”
While it is true that borrowing capital enables a business to take actions or grow at a pace that would not be sustainable otherwise, it also causes that business to be less flexible and incur higher risk. The more the business borrows, the more it spends towards debt payments and interest. Cash flow is impacted as well as net profit. Combine this with extending credit to customers, and it is possible to experience serious cash flow situations. It is a sobering reality that many companies have failed from lack of cash more than anything else.
Five points to consider
Becoming a debt-free business, or building one from the ground up, is a lengthy process. But there are some strategic points that must be embraced if you are to succeed:
- You need to know — intimately — the true cost of delivering your service or product.
- Become crystal clear as to where the money goes.
- Develop and use an operating budget as a decision making tool.
- Always know your financial condition and situation — know the numbers and operate your business with this knowledge in mind.
- Consistently measure revenue, gross profit, and cash.
While there are no guarantees in life, it is certain that as a small business owner you will sleep better at night knowing that your business is stronger and more secure in these uncertain times as a debt-free operation.
If you want help on strengthening your financial systems, download our free guide.